Key Variables in Coming Weeks

Late this week Europe is again faced with an EU-wide 27-country summit with no clear direction. The more positive tone of early June -- when Europe focused briefly on constructive ways to use the new ESM to add capital to Spain's banks – has faded. The euro-zone isn't making progress on creating a mechanism to share some of the periphery's huge legacy debt built up during euro-wide violations of the Maastricht deficit guidelines, and the periphery isn't taking the much-needed steps to downsize governments and government controls to allow private sector growth.

• The four-country Rome meeting on June 21 between Merkel, Monti, Hollande and Rajoy agreed on a "growth package" of 130 billion euro. They didn't give details, which wouldn't matter anyway in that the package is small and aimed at growth through bigger government rather than a bigger private sector.
• German economic data is weakening, with the counterproductive effect of turning German public opinion against the periphery's debt problems and, for now, against the euro. (Germany's IFO and business confidence were weak.)
• In Rome, Chancellor Merkel agreed to move forward with a financial transactions tax for a subset of the euro-zone countries. We think it’s a particularly harmful type of tax. The proceeds will be used to fund future bank rescues. Her support was apparently a condition for SPD support of the ESM in the Bundestag (two-thirds approval vote expected the first week of July.)
• Merkel maintained her opposition to using joint bailout funds (like the EFSF and/or ESM) to directly recapitalize banks in Spain or other countries. She said “liabilities and controls go together.” This has two points: the bailout facilities wouldn’t have control of a bailed out Spanish bank; and it wouldn't be acceptable for an international facility to have control of bailed out banks, whether in Spain or potentially in Germany.
• Merkel also opposed granting the ESM a banking license that would allow the ESM to leverage itself. The current design is for the ESM to get appropriated funds from euro-zone countries based on their size, but then lend the money only once, say to a Spanish government banking agency. Germany has resisted enlarging the ESM through leverage -- becoming a bank in order to access the ECB discount window, buying derivatives (like a call option on a Spanish bond as a way of increasing the ESM's impact), using its capital to issue guarantees or insurance on bonds, or issuing debt against its assets in order to increase its total balance sheet.
• And Greece's post-election proposal for renegotiating its austerity program has widened the gap with Germany by requesting a reprieve in government worker layoffs and pension reductions and a cut in the VAT on food to 13% from 23% (viewed in Germany as Germans paying taxes so Greeks can eat more expensive foods.) The new Greek coalition's prime minister and finance minister will not attend the EU summit, reviving Germany's May complaint that there was is no one in Greece with whom to negotiate. The troika negotiations with Greece need to move quickly, since Greece is out of cash and way above its deficit target. Yet Greece is launching the negotiations so confrontationally, perhaps with French encouragement, that it is sure to create new rancor in Germany.
• We think Europe and the euro will deteriorate and drag down world growth expectations until/unless Germany establishes a more powerful mechanism for lowering periphery bond yields and the periphery takes confidence-building measures to show that they will downsize their governments. There's a positive-sum opportunity due to the super-low borrowing costs for the more credit-worthy countries and the dynamic growth implications from smaller government, but Europe is not moving in that direction yet.

We don't think the EU summit will make much progress late this week. The more important action is in the periphery, at the ECB, in the details of the Spanish banking bailout, and in Germany as the ESM is finalized.

• The periphery shows signs of getting worse in terms of the economies, deficits, and expectations for external assistance. This deterioration will set the pace of the crisis, including the intensity of Greece's cash flow collapse.
• The ECB will probably cut the policy interest rate on July 5 to 0.75% from 1% and the discount rate to 0% from 0.25%. Markets would applaud but it doesn't provide enough private sector stimulus to stop the deterioration in growth. The ECB eased its collateral requirements on June 22 and might take more steps in this direction in support of weak banks. The Bundesbank has been complaining about the erosion of the quality of the ECB's assets but hasn't been able to stop the trend, a signal that Germany has lost its dominance of the ECB -- though we think the ECB's price-stability mandate is still a stronger rudder than the Fed's structure.
• Germany might allow the bank bailout loan to Spain to have equivalent seniority (rather than preferred status) to private sector bondholders in the event of a debt restructuring. The details of the Spanish banking bailout are still being worked out. We think Germany is firm that the loans have to go to some part of the Spanish government, not directly to the banks, but it may have some flexibility on the seniority of debt in Spain's capital structure. If so, it would be quite positive, creating a favorable precedent and contrast with ECB bond purchases (which take precedence over private sector holders and therefore undercut the market.)
• Germany is in the process of finalizing its approval of the ESM this week and next. The details matter. We don't think the Bundestag will approve more ESM funding or explicitly approve leverage, but it might leave enough flexibility that the ESM's powers could become strengthened later. We don’t think Hollande's call for the issuance of Eurobonds (joint euro-zone debt) has resonance, but it is conceivable that the ESM might begin creating some joint liabilities through leverage, debt issuance, guarantees or insurance.

David Malpass is President of Encima Global and Chairman of GrowPac.com’s Stop the Fed campaign.